Today’s chart of the day looks at the market from a technical perspective. While there are a plethora of Wall Street analysts calling for much higher levels for the S&P 500; most of these calls are based simply on the belief that the current trajectory must continue indefinitely. While you certainly cannot “fight the Fed” the underlying fundamentals and economics that support the markets long term are not present for the party. What is very important to understand, and can be clearly seen in the chart below, is that despite repeated calls for “ever rising” stock markets in the past eventually left investors devastated. Markets do not, and cannot, continue indefinitely in one direction.

Market prices are subject to gravity (the long term moving average) and the longer the duration of the moving average the greater the “gravitational pull” that exists. One way to measure extremes of price movement is through the use of standard deviation. One standard deviation from the mean (average) encompasses 68.2% of potential outcomes within a given distribution of data which, in this case, are market prices. Two standard deviations encompass 95.8% of all potential outcomes while three standard deviations encompass 99.8% of all potential outcomes.

The chart below shows a MONTHLY chart, which is a very slow moving analysis, of the S&P 500 overlaid with Bollinger Bands which represent 2 and 3 standard deviations of a very long term (34 month) moving average.

At the peaks of the “Internet Bubble” and the “Credit/Housing Bubble” the market never got significantly above 2-standard deviations. Today, we are encroaching well into 3-standard deviation territory. Standard deviation analysis tells us that roughly 99% of the potential movement in prices, from the bottom of the correction in 2011, has been achieved. Furthermore, the extension of the market above the long term moving average is also at levels that have previously been associated with major market tops.

The top graph is a very long term (150 month) measure of overbought and oversold conditions. It is also warning that the current market environment is stretched very far and that further gains are likely to be limited without a correction first.

However, therein lies the potential problem. Looking back at the markets during a bullish trend the market is usually contained between the long term moving average and 2-standard deviations above the mean. However, when the extension is above the long term mean subsequent corrections are generally more associated with mean reversions. A mean reversion is where prices fall an equal distance in the opposite direction or well below the long term moving average.

The current level of overbought conditions combined with extreme complacency in the market leave unwitting investors in danger of a more severe correction than currently anticipated. A correction to the long term moving average (currently around 1350) would entail an 18.5% correction. A correction to 2-standard deviations below the long term moving average (which is most common within a mean reversion process) would slap investors with 33% loss.

If you don’t think a 33% loss is possible you should be aware that that is about the average draw down of the markets during a normal recessionary cycle. Not only is such an event possible – it is probable when, not if, the economy slips into an eventual recession.

IMPORTANT: We are currently invested n the market and I am not suggesting that you sell everything and move to cash. What I am saying is that the market is very extended and the risk of a correction of some magnitude has increased significantly this year. Therefore, if you are close to retirement, or simply just can’t afford the risk of a major market correction, then you may want to start reducing some of your portfolio risk and begin to build in some hedges against an unexpected event. Whatever eventually trips up the market will be “unexpected.”

Currently, it seems that most of the world’s concerns have been put behind us due to the massive injections of liquidity being injected by the Federal Reserve, BOJ, ECB and China. The Eurozone crisis has disappeared, recessions in the Eurozone and weak US economic data are of little concern, declining revenue and earnings are readily dismissed as the primary driving force for investors is Fed interventions. However, it is within this complacency, that an unexpected turn of events can pull the rug from beneath the markets and send money racing for the sidelines. Unfortunately, for most individuals, by the time they realize what is happening it will likely be far too late to act.

About The Author

Lance Roberts – Host of Streettalk Live

After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.